Hedging strategies used in Petroleum Market- Influencing Petroleum Prices in EU

Hedging strategies used in Petroleum Market- Influencing Petroleum Prices in EU

Introduction

As the structure of world industries changed in the 1970s, the expansion of the oil market has continually grown to have now become the world's biggest commodity market. This market has developed from a primarily physical product activity into a sophisticated financial market. Over the last decade, crude oil markets have matured greatly, and their range and depth could allow a wide range of participants, such as crude oil producers, crude oil physical traders, and refining and oil companies, to hedge oil price risk. Risk in the crude oil commodity market is likely to occur due to unexpected jumps in global oil demand, a decrease in the capacity of crude oil production and refinery capacity, petroleum reserve policy, OPEC spare capacity and policy, major regional and global economic crises, and geopolitical risks. A futures contract is an agreement between two parties to buy and sell a given amount of a commodity at an agreed upon certain date in the future, at an agreed upon price, and at a given location. Furthermore, a futures contract is the instrument primarily designed to minimize one's exposure to unwanted risk. Futures traders are traditionally placed in one of two groups, namely hedgers and speculators. Hedgers typically include producers and consumers of a commodity, or the owners of an asset, who have an interest in the underlying asset, and are attempting to offset exposure to price fluctuations in some opposite position in another market. Unlike hedgers, speculators do not intend to minimize risk but rather to make a profit from the inherently risky nature of the commodity market by predicting market movements. Hedger want to minimize risk, regardless of what they are investing in, while speculators want to increase their risk and thereby maximize profits. Conceptually, hedging through trading futures contracts is a procedure used to restrain or reduce the risk of unfavourable price changes because cash and futures prices for the same commodity tend to move together. Therefore, changes in the value of a cash position are offset by changes in the value of an opposite futures position. In addition, futures contracts are favoured as a hedging tool because of their liquidity, speed and lower transaction costs.

Hedging is any strategy designed to offset or reduce the risk of price fluctuations for an asset or investment. Hedging should not be confused with hedge funds, which are private investment funds that often, but not always, employ hedging strategies. When an investor buys or sells a security, the investor bets that the price of the investment will move in a certain direction. As with any bet, there's always the risk of losing money if the price moves in the opposite direction. An investor hedges against this risk if he employs any tool or strategy that minimizes this risk. In general, creating a hedge requires the purchase of a second asset with a negative correlation to the ...